Saturday, July 26, 2008

ANWR, OCS, And “Supply and Demand”

In the last post about drug addictions relation to oil demand I briefly covered some of the basics of why Oil is different then most other product. But here is a better description for those who are interested in a better understanding.

Supply and demand are a relationship by which market prices are set in a successful business. It is the most basic, day one, concept of economics. Just knowing that increased supply and demand decreased can lower prices for a product is not going to get you your masters in economics. As a matter of fact it is about as close to it as a guy who masturbates is to getting a doctorate MD. There is so much more to it then that. I will try to explain its relationship to oil.

Like I said, supply and demand are a relationship. One must respect the other when trying to determine affects on the market. Demand is a factor that reduces in quantity as price is increased. A key element of demand is the phrase “willing and able”. Bata VCRs are not flooding the shelves of you local Wal-Mart because nobody is willing to buy them at any price. Any supplies of Betas are dead inventory. By the same token there are only about 50 Koenigsegg CCRs produced per year. It turns out that there are very few people “able” to pay 3/4 of a million dollars for a car. (It doesn’t have the greatest fuel economy either.) Many are willing but not able.

The demand for oil is increasing. China is estimated to put 25,000 cars on the road per year. It is also estimated that they will have more cars on the road then the US in the next 10 years. India is another emerging economy. It is not sure what pressure they will put on the auto market, but the energy market in general will feel the upward push in demand. So, Why not just throw supply at it?

Let us take a look at supply. Supply is the amount that the producer has decided the market will buy at the maximum price. That point where the market is satisfied and doesn’t need anymore is “one too many”. It is also called it equilibrium point. If 20 people want your product and you produce 10, then the price you can ask will be more. The 10 that get it will be the 10 most “willing and able.” The other 10 will do without.

Anything produced falls into two categories. Some fall into both. Every product is at least either a Luxury or a necessity. You need a home. Anything above a warm dug out hole in the ground is considered a luxury. Almost all products have “substitute goods”. Butter has margarine, corn has peas, and beer has wine. Gasoline has substitute products, however, they are very undesirable to most transportation energy consumers. Its substitutes are E85, natural gas, walking, biking, and renewably generated electrical energy are most notable. Many of these options are not even feasible for most consumers. To further complicate the situation, the American culture is designed in such a way that using gasoline is required as a way to continue prosperity. If you are not able to pay for gasoline, you are not going to work, and you are not going to be able to for necessities, let alone luxuries for very long.

In contrast, the Saudi Arabian culture is not as tied to the use of gasoline. They actually produce way more oil then consume. Oil in the ground is like money in the bank for them. Their economy is positively affected by oil price increases. Drilling in ANWR will not change the economic equilibrium price. That point where maximum price is charged for the least quantity produced. That just means that if one supplier increases supply, a second producer can actually maintain its bottom line by simply reducing supply. This is especially true if your are predominantly a supplier and not a consumer of the product. Saudi Arabia’s economy is positively effected by increases in prices on crude oil. The US economy is not.

This is why supply and demand argument doesn’t hold weight in our economy. Getting off the stuff does.

2 comments:

Anonymous said...

You say that opening drilling in ANWR won't effect the cost of oil, but can't we as the U.S. who is drilling for our own oil charge ourselves a lower cost for the oil we actually have in our own ground?

Lord of Logic said...

You are holding a couple of misconceptions that are common among most people. The main one is people think “the government” owns the oil that is extracted. They do not. The companies that buy the leases own the oil.

Most of them are not strictly American owned. I once worked for Phillips Petroleum in their Benzoyl Peroxide facility. Phillips was a British owned Company, headquartered in Germany, with nearly half of it’s major production facilities here in the states. The "price of gas" is what matters to most of us. The supply chain that moves petroleum from the ground to the gas tank is never wholly American.

A better way to describe what happens to oil is to consider what used to go on at the Ridge Tool factory I used to work at right out of high school. We once made, packaged, and shipped to location pipe wrenches that had “made in Korea” written on the box and on a tag we stuck in the box. I saw the metal get delivered on the pallets with the rest of the raw parts right from the foundry down the street. We machined them right there. Then we shipped them. What did that have to do with “Korea”? I asked one of the salesmen. He said that they regularly worked deals. Foreign producers would send their specs and molds to a like competitor overseas. They would agree to produce each others parts one-for-one in order to gain many mutual benefits. Logistics being the most predominate. Shipping 100s of thousands of tons of steel across the water can be costly. So they just traded across instead.

Oil works the same way. These companies might deliver American drilled oil from American soil. But really in the end they are selling oil that was originally sold on the open market to the Americans from the Saudis. But the American sold theirs to the Chinese. The Saudis and the Americans agree to save each other money by delivering from the nearest supply. Let us face it, oil is oil.

In the end all of these companies answer to their share holders first. What do you think would happen if those companies said to their stock holders, “we are going to sell our oil at a lower cost to just the Americans, thus reducing our own profitability.” My guess is the next day they wouldn’t have stock holders. Especially the foreign ones who actually have money to invest these days. Besides that, the reduction in global supply would increase the price of oil. That would be blamed on the US. Many of our suppliers would get mad and reduce the amount they sell to us. Since we only produce 2% and consume 25% of the global production, that would be very bad in the very short and long run.

I was planning on talking about this in my next post on Oil, So you may see you questing posted and answered in a main heading.

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